Tuesday 12 July 2016

Rules of the game

Playing by the rules is an important element underpinning the economic system in which we operate. Indeed, it was to avoid a repeat of lawless behaviour in the increasingly globalised world of the 1930s that prompted the design of many elements of the current international order (trade agreements, international supervisory bodies and the safety mechanisms designed to prevent conflict). But we should not make the mistake of believing that all rules are good rules.

I was reminded of this when reading an article in The Economist recently which illustrated the case of the US Fourth Amendment bar on “unreasonable searches and seizures.” The article pointed out how the US Supreme Court has ruled that loopholes in the law make it admissible to use evidence gathered in one legal case to prosecute another. As one of the Supreme Court judges who opposed the ruling warned, “Do not be soothed by the opinion’s technical language. This case allows the police to stop you on the street, demand your identification, and check it for outstanding traffic warrants.”

Now you may be wondering what this has to do with economics, but it is just a fancy way of saying that the law of unintended consequences can do an awful lot of damage. Think of the operation of the Stability and Growth Pact in the euro zone. It was originally designed to prevent taxpayers in Germany from having to bail out their less fiscally rigorous neighbours in southern Europe. This seemed like a good idea at the time but the adherence to strict fiscal rules has been one of the factors exacerbating the extent of what can only be called a depression in places such as Greece. Indeed, the rules are inherently deflationary and, as Keynes put it, make the process of adjustment compulsory for the debtor and voluntary for the creditor.

Worse still, although there were explicit rules for the ratio of public deficits and debt relative to GDP, to which economies were supposed to adhere, they were observed more in the breach. By 2001, two years after the euro came into being, Germany had already pushed its deficit through the 3% of GDP level (as indeed had Greece and Italy) with France following a year later. Once Germany and France had breached the deficit targets it became difficult to ensure that other countries could be forced to comply. So not only were the rules ill-designed, but they quickly became non-credible.

Here in the UK, the question of rules has gained lots of prominence in recent days in the wake of the EU referendum and various leadership elections in the main political parties. Prime minister elect Theresa May has already suggested that she will not seek to overturn the result of the referendum and will adhere to the rules of the Single Term Parliament Act and not call an early general election. But if she does eventually trigger the Article 50 process, in accordance with the perceived wishes of the people, she will be unleashing a wave of consequences we cannot yet begin to predict. In economics, just as in law, it pays to be certain of the long-term consequences before  simply following a predefined set of rules.

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